As financial institutions and private equity firms focus on recovery from the subprime mortgage crisis, government investment vehicles known as Sovereign Wealth Funds (SWFs) are emerging as key players in global M&A. Quite apart from the spotlight cast on them by their recent (and heroic) intervention in the financial markets, including investments in Citigroup, Bear Stearns, Morgan Stanley and Merrill Lynch, SWFs are attracting widespread international attention because of their dramatic growth. No longer the almost exclusive preserve of the traditional oil exporters,1 they are being established in significant numbers in Asian export economies as well as in Russia and other emerging natural resources powers. According to one recent estimate, the holdings of SWFs worldwide may top US$12 trillion by 2015.2 Another important development is a shift in investment strategy away from lower-yielding bond investments towards equity investments and (most significantly) key strategic assets.
In light of this phenomenal growth, SWFs and other state-owned enterprises (SOEs) are coming under enhanced scrutiny from the governments of countries in which they invest. On February 27, 2008, the European Union became the latest jurisdiction to address SWF investments, issuing a communiqué in support of a common European approach to SWFs in advance of the upcoming Spring 2008 meetings of the European Council.3 This followed the announce¬ment of SWF investment review policies by Australia and Canada, whose highly developed resource-based economies are prime targets for SWFs. A recent issue of Stikeman Elliott's M&A Update reviewed the Government of Canada's new SOE guidelines ("the Guidelines" 4), summarizing the Government's concerns over the possible non-commercial orientation of some SOE/SWF investments and with respect to their adherence to Canadian standards of corporate governance and transparency.5
Sovereign Wealth Fund investment under Canada's new guidelines
It should be noted at the outset that certain types of investment may not be significantly affected by the Guidelines. First, the Guidelines do not apply to acquisitions that are not large enough to be reviewable under the Investment Canada Act,6 nor do they capture minority investments. For SWFs seeking to take smaller portfolio stakes in Canadian companies (e.g., less than one-third of the voting shares for non-cultural businesses), it will be "business as usual".7 Second, sectoral laws already restrict foreign investment in a number of critical sectors such as airlines,8 telecommunications,9 banking10 and publishing.11
Given the political sensitivity of foreign state investment, the Guidelines' biggest impact may be felt where SWFs and other SOEs make substantial investments in critical resource and infrastructure projects - targets of particular interest to such investors. In Canada, as in the U.S. and elsewhere, the political dynamics associated with such investments may well be complex and challenging. The Guidelines have sent a signal that the state status of the investor, not previously a consideration in the review of foreign investments under the Investment Canada Act, will result in close scrutiny. Government concerns over significant investments in key Canadian assets, exacerbated in many cases by a public hue and cry, may well compel the Government to establish demanding conditions for approval, a prospect that may be unpalatable to many SWFs.12 For example, the Guidelines indicate that the Government could require a state investor to list the acquiring company or the target company on a Canadian stock exchange and comply with Canadian standards of corporate governance (such as adding independent directors to its board).13 The Guidelines also do not preclude the possibility that the Government might scrutinize the SWF's record as an investor in other countries, including its home state, during the investment review process.14
SWF partnerships with Canadians
To allay Government and public concern over potential foreign state control of high profile Canadian businesses in key sectors, SWFs may consider structuring partnerships with Canadian pension funds, Canadian-controlled private equity firms or other Canadian pools of capital.
One approach would be for the SWF to take only a minority equity stake in the acquisition vehicle, with Canadian partners holding a majority, with the result that the acquisition vehicle would be regarded as Canadian. This type of structure would be similar to that used by Canadian pension funds or private equity in several large-scale acquisitions in sectors in which foreign ownership is restricted to a minority non-controlling position.
Still, there may be challenges with such partnerships. If Canadians own the majority of the equity in an acquisition vehicle and the SWF has only a minority holding, the SWF may balk at not having control in fact or at ceding significant power to its Canadian partners (e.g., majority of board members, operational control, etc.). Another complicating factor is the limited number of Canadian pension funds and other sources of capital in Canada that are of sufficient size to participate significantly in a major infrastructure or resource bid, which can make it difficult to "Canadianize" the investment vehicle. While Canadian pension funds and other institutional investors may be subject to statutory or other restrictions on their level of ownership or control of acquisition vehicles, a number of acquisition structures have been successfully employed in the past to mitigate the effects of these restrictions.
A second approach would be for the SWF to assemble a syndicate of Canadian and non-Canadian investors. If, for example, there are three investors (a foreign private equity player, an SWF and a Canadian) each with approximately the same share of the acquisition vehicle, the vehicle, while a non-Canadian under the Investment Canada Act, may not be considered to be an SOE under the Guidelines. A potential weakness with this strategy is that the Guidelines do not offer any bright line demarcation of when an acquisition vehicle is state-controlled. However, the SWF may be able to counter this difficulty by showing that it operates at arm's length from its home state and has investment objectives that relate solely to maximizing revenue. Even if the acquisition vehicle is characterized as state-owned and is therefore subject to the Guidelines, the fact that the SWF has an arm's length relationship with the home state and has commercial objectives would in any event likely reassure the Government that the SWF may be treated as similar to private capital.
A third option is for the SWF to acquire a control in fact position in the acquiring entity while at the same time cementing a partnership with Canadian investors that reassures the Government that despite being a foreign state-owned enterprise, the SWF is entering the market for commercial reasons rather than for political, national or other similar objectives. If the Canadian co-investor has negative control (i.e., the ability to veto certain fundamental actions by the SWF in relation to the acquisition vehicle), Government and public concerns that the acquiring entity would act contrary to Canadian interests might well be mollified.
A potential limitation on any of the above three strategies would arise if the SWF has different investment objectives than possible co-investors. For example, an SWF that is interested in acquiring control of strategic assets in Canada may be less concerned about traditional transactional issues such as purchase price, deal premiums, return on investment, liquidity alternatives or any agreement to give substantial undertakings to the Canadian Government, given its longer term investment horizon and strategic goals. This may be at odds with the objectives of Canadian or U.S. pension funds, private equity groups or other financial players which tend to look to traditional return on investment measures.
SWFs in Canada going forward
SWFs seeking to invest in large Canadian companies, particularly those that are viewed as icons in critical sectors of the Canadian economy, may be well advised to explore partnerships with Canadian private equity, pension funds or other Canadian pools of capital. Ultimately, the success of SWFs will depend not only the nature of the investment and the industry but on creative deal making that goes beyond traditional financial and economic issues to address political and other concerns.
The authors wish to thank their colleague Andrew Cunningham for his assistance.
1 Note that SWFs are not a new phenomenon, having been established as early as the 1950s in a number of oil-rich jurisdictions. The Alberta Heritage Savings Trust Fund, established in 1976, is a Canadian example.
2 Stephen Jen, "How Big Could Sovereign Wealth Funds Be by 2015?", Morgan Stanley Research, May 3, 2007.
3 "A common European approach to Sovereign Wealth Funds" (Brussels: Commission of the European Communities, February 27, 2008).
4 "Guidelines - Investment by state-owned enterprises - Net benefit assessment" (Ottawa: Industry Canada, December 7, 2007).
5 See Sandra Walker, "New guidelines for Canadian investments by foreign state-owned enterprises", M&A Update (Stikeman Elliott LLP, February 2008). Note that national security is not the focus of the Guidelines. Indeed, it is currently anticipated that the Government will introduce an amendment to the Investment Canada Act to permit the review of foreign investments on national security grounds.
6 With the exception of investments in transportation, financial services, uranium production and cultural businesses (the "sensitive sectors"), the review threshold for direct acquisitions of Canadian businesses is set at a book value of assets of the target of CDN$295 million. For the sensitive sectors, the review threshold is set at CDN$5 million.
7 For example, Norway's Government Pension Fund - Global has invested for years in foreign equity by taking passive minority stakes in companies.br /> 8 For example, foreign ownership of shares of air service companies is limited to 25%. In addition, there is a "control in fact" test that scrutinizes the influence of parties that might be non-Canadian over the affairs of the company.
9 Telecommunications common carriers must be Canadian owned and controlled. Among other requirements, not less than 80% of the carrier's voting shares are beneficially owned by Canadians.
10 Any person seeking to acquire or hold more than 10% of any class of shares of a bank must obtain the prior consent of the Minister of Finance.
11 The Department of Canadian Heritage has established policies that prohibit the acquisition of Canadian controlled book publishing and film or video distribution businesses.
12 Prohibitions of proposed investments have not occurred to date in Canada, outside the cultural industries sector.
13 Note that on March 2, 2008, an official of the China Investment Corporation, a US$200 billion SWF, publicly affirmed its commitment to transparency and independence from government.
14 In California, legislation was recently introduced that would restrict pension funds Calpers and Calstrs from investing in (or in funds managed by) private equity firms that are wholly or partly owned by a SWF and fail to meet transparency and (with respect to its parent government) human rights tests. California Assembly Bill No. 1967, "An act to amend Section 16642 of, and to add Section 7513.8 to, the Government Code, relating to investments."